No More Imbalances? No Chance.

Economic history is a succession of market imbalances. Ridding ourselves of the imbalances to get to an ideal equilibrium point is a meritorious goal that might never be realized, leaving us to ponder the next set of imbalances that are going to dominate our decision-making.

The economic strife of 2008 arose from a series of long festering and connected imbalances: unrealistic expectations about real estate prices funding unsustainable consumption abetted by market friendly monetary policies which kept asset prices aloft in a deregulated world in which unsupervised financial product risks were allowed to flourish.

Simultaneously, demographic forces were increasingly constraining growth in many advanced economies while causing growth elsewhere to accelerate. Dissaving advanced economies were relying more heavily on the savings of the emerging economies to fund their spending.

These broad patterns were widely recognized as unstable but not so electorally unpopular that individual governments were prompted to take action to ease the transition toward something more long lasting.

In China, for example, reason and ideology converged on a need to improve urban living standards. In the United States, no government had the nerve to decry the right of poor people to home ownership no matter how inadequate their savings or income.

Not surprisingly, and entirely consistent with how imbalances are typically resolved, the pressures for change eventually became too great and markets began to force an adjustment. Unfortunately, adjusting markets are not a pretty sight and governments stopped them running their full course.

Clearly, there would have been enormous individual hardship across the globe if intervention against the market had not occurred. Nonetheless, the intervention has not necessarily taken us to a sustainably better place. There are now other imbalances that need to be addressed.

For Australia, one consequence of immediate interest is a rising exchange rate. Most analysts would say that its longer term equilibrium path, based on relative inflation outcomes, is somewhere below its current position. Even so, departures from what could be construed as fair value can be long lasting. Deviations for five years or more may not be out of the question before a reversal occurs.

There are beneficiaries of a higher exchange rate. Political leaders will always regard a rising exchange rate as being better than a falling rate. Consumers will be able to spend less on their purchases of imported durable goods. At the same time, a higher exchange rate will undermine the competitiveness of Australian import competing manufacturers imposing downward pressure on production and employment. However, this will ensure that interest rates are lower than they otherwise would have been with lower mortgage rates and a more contented construction sector.

Australia's exchange rate imbalance is tied up with global growth patterns. Asian emerging economies appear likely to grow faster than advanced country economies for several years, at least. Capital flows are likely to favour the emerging market economies.

In the short term, Australia will benefit from these conditions. Its commodity exporters will reap the financial rewards and, nationally, the terms of trade will be more favourable helping to boost real incomes. Competitive exporters or those selling specialized products or services will benefit from being close to strongly growing markets.

These conditions could result in Australia's inflation pressures being stronger than in other advanced economies. That could open up a wider or more sustained interest differential, given the apparent disposition of the Reserve Bank, which will also help to support a high, or even more significant rise, in the exchange rate.

To the extent that they seek to limit the upward pressure on their exchange rates, emerging economy governments will eventually have to constrain monetary growth in various ways including through higher interest rates and quantitative controls. This might well prove unpalatable giving us a new imbalance and another adjustment in waiting. The longer emerging country policymakers delay this outcome, the more dramatic the subsequent adjustment is likely to be.

Advanced country governments will not allow their economies to shrink without a fight. They will try to boost growth as best they can. They might fail and, in the process, further exacerbate some of the already evident fiscal and monetary imbalances. Alternatively, they might eventually succeed in, say, three or four years in which case some of the building inflation and interest rate pressures in Australia could become even more severe causing a reversal of the currency appreciation which will have occurred by then.

In short, we need to get used to an economic world making more frequent adjustments. And, although we might have an eye on the ideal of where we might like to go, it could be a case of a dream never quite being realized.

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